In response to immense public and political indignation at the credit rating sector during the financial crisis, the EU legislature introduced a comprehensive regulatory framework for credit rating agencies in 2009 (‘CRA Regulation’). Seven years later, the focus of public opinion has shifted to other ‘hot’ topics, such as the historically low interest rates on savings and the scandals surrounding Deutsche Bank. However, for the parties involved in the CRA Regulation, an important stage has yet to come: evaluating the effects of the regulatory framework on the credit rating sector.
By introducing the latest version of the CRA Regulation (Reg. 462/2013), the EU legislature had the objective to, inter alia, mitigate potential conflicts of interest in the CRA-market, ensure the high quality of ratings (partially through increasing competition between CRAs) and decrease over-reliance on ratings. Noteworthy examples of measures in the CRA Regulation aimed at reaching these objectives are, respectively, the rotation-provision (Article 6b), the double rating-provision (Articles 8c-8d) and the policy to reduce regulatory references to ratings (Articles 5b-5c).
At first glance, these measures seem likely to contribute to the objectives of the CRA Regulation. In this blog, we will discuss the first effects of these measures as presented by the Study on the Feasibility of Alternatives to Credit Ratings (December 2015) and the Study on the State of the Credit Rating Market (January 2016), both published on the website of the European Commission. These studies show that the effectiveness of these provisions still leaves much to be desired.
First, the rotation-provision (Article 6b) prescribes that the CRA that enters into a contract to attach ratings to re-securitisations (repackaged securitised products) shall not issue ratings on new re-securitisations with underlying assets from the same originator for a period exceeding four years. It primarily aims to decrease potential conflicts of interest that occur due to the fact most CRAs are paid by the very issuers of debt instruments they are supposed to impartially rate (issuer-pays model), which creates an incentive to inflate ratings. Furthermore, expectations were that the rotation-provision would increase competition in the credit rating industry, which is dominated by the ‘Big Three’ (Standard & Poor’s, Moody’s and Fitch).
For a number of reasons, at present, the effects of the rotation-provision are limited. First, the overall impact of this provision is small because the quantities of issued re-securitisations have decreased drastically since the global financial crisis. Secondly, only a limited amount of CRAs in the EU is able to rate (re-)securitisations. As a consequence, CRAs have little incentive to compete; some small CRAs therefore plea for an expansion of the provision to other financial instruments. Thirdly, as CRAs are forced to rotate, their ability to perform an ongoing self-assessment of their ratings – which is deemed to be crucial in the development of rating criteria and analysis – is being reduced and, moreover, the rating costs of issuers might increase severely. This situation has even prompted questions as to whether the benefits of Article 6b outweigh its costs.
Secondly, the double rating-provision (Article 8c) obliges issuers of structured finance instruments (SFIs) to appoint at least two CRAs to provide credit ratings independently of each other. Furthermore, Article 8d prescribes that issuers shall consider appointing at least one CRA with no more than 10% of the total market share. These provisions aim to stimulate competition in the credit rating industry. At present, however, they fail to do so to a large extent. Of the twenty-six CRAs in the EU, only nine offer ratings on SFIs as of 2015. Moreover, the Big Three still hold almost 95% of the market share in SFI-ratings as of 2014, due to a lead in expertise and reputation. This situation is left unsolved by Article 8d, as issuers can deviate from the Article when they can convincingly explain such a decision. Issuers seem to do so frequently, because the reputation of small CRAs is often considered insufficient.
Thirdly, Articles 5b-5c aim to reduce over-reliance on credit ratings by reducing the use of credit ratings for regulatory purposes. Under Article 5b, the European Supervisory Authorities (EBA, EIOPA and ESMA) may not refer to credit ratings in guidelines, recommendations and draft technical standards (and were obliged to remove current references) if they have the potential to trigger ‘sole or mechanistic reliance’ on ratings. Under Article 5c, references to credit ratings in EU law also have to be deleted if there are appropriate alternatives available. In practice, removing references to ratings is easier said than done, especially because appropriate alternatives to credit ratings are not always easily available. Although efforts have been made, references to ratings can still be found in important pieces of EU legislation such as the Capital Requirements Directive (CRD IV) and the Capital Requirements Regulation (CRR) for the banking sector and the Solvency II Directive and its Delegated Regulation for the insurance sector, so that market participants may continue to (have to) rely on credit ratings.
As the measures discussed above were only introduced in 2013, more time is necessary to analyse their long-term effects. However, especially as regards the goal to increase competition between CRAs (thereby decreasing the concentration of the CRA market), the expected effects of the measures discussed above are minimal. Seven years after the first version of the CRA Regulation was introduced, the Big Three still have a market share of almost 92% according to ESMA’s market share calculation (2015) and a prognosis made for 2015-2020 shows no substantial changes in this respect.
Notwithstanding their small coverage in terms of time, the recently published studies serve an important purpose. They not only show that achieving significant changes in the credit rating sector takes time and effort, but also that there are structural problems – for instance, market concentration and conflicts of interest – in the sector that need to continue to be addressed. Therefore, in order to preclude history from repeating itself, the credit rating industry should remain a centre of attention of the EU legislature and supervisors so that in the long run, the EU will get a grip on the credit rating sector.